[Hemendra is a student at Hidayatullah National Law University.]
Recently, an interim order was issued by the Securities and Exchange Board of India (SEBI) which barred Axis Capital Limited (ACL) from accepting any assignment as a merchant banker (MB), arranger, or underwriter for the sale of securities in the debt segment until further notice. ACL as a merchant banker is regulated by the SEBI (Merchant Banker) Regulations 1992. As per Regulation 2(1)(cb), MB means “any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities or acting as manager, consultant, adviser or rendering corporate advisory service in relation to such issue management”.
ACL had offered a guarantee for the non-convertible debenture (NCD) of Sojo Infotel Private Limited (Sojo) under the pretense of underwriting, which is impermissible under the existing merchant banking regulatory framework therefore an interim order was issued against it by the regulator. Sojo had pledged Lava International Limited (LIL) shares as collateral for the NCD issued. As per the debenture trustee deed (DTD), the Debenture Trustee would enforce the pledge in the event of a default. In case ACL is unable to find buyers for the pledged shares, the DTD requires ACL to meet its "underwriting commitment" by either purchasing or funding the purchase of these pledged shares.
This case not only highlights the blurred lines between underwriting and prohibited guarantees. but also reflects the wider compliance challenges encountered by financial institutions operating in a dynamic regulatory landscape. This post firstly analyses the rationale behind the SEBI’s action. Second, it delves into the intricacies of compliance challenges confronted by merchant bankers. Third, it raises questions on the ACL activity, specifically whether it should be classified as a compliance failure or regulatory breach. Lastly, it analyses the implications for future merchant banking in India and suggests a potential solution to these challenges.
Rationale Behind SEBI's Action
Regulation 13A of MB regulations prescribes that no merchant bankers (other than banks and public financial institutions) shall carry on any business other than that in the securities market. They can take risks associated with the market but not the risk of repayment in case of issuer default. In the case at hand, ACL provided indemnity / guarantee for the redemption of NCDs, disguising it as underwriting, which was not allowed under the current regulatory framework.
“Such activities threaten the financial system by potentially disturbing the orderly functioning of the market”, as postulated by SEBI in its order. SEBI's action against ACL demonstrates the compliance challenges confronted by MBs in the capital markets.
Treading Compliance Challenges in Merchant Banking
The MBs face numerous hurdles while adhering to the capital markets regulations. First, as evident from Regulation 13A of the regulations, merchant bankers are primarily those who are involved in the business of issue management and associated activity in the security market. There is a need to clearly define these activities and integrate them directly into the regulation. MBs often undertake activities extending beyond the security market for instance private placement activities pertaining to unlisted companies, advisory services for projects, and syndication of rupee term loans, etc. By segregating them merchant bankers can hive off such activities to a separate entity. Moreover, while regulations allow merchant bankers to assume market risks, it becomes challenging for them to transverse the fine line between acceptable risks and prohibited repayment guarantees which often lead to compliance failures due to lacunae in the definition under Regulation 13A.
Secondly, merchant bankers are allowed to act as underwriters under Regulation 7 of the regulations. The underwriter can subscribe to the unsubscribed portion of an issue under the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2018. Specifically, Regulation 14(1) of these regulations allows merchant bankers to underwrite the issue, including subscribing to any portion of the issue that remains unsubscribed by the public. Acting as both an investor and underwriter creates a potential conflict of interest which jeopardizes their fiduciary duties to other clients or investors.
These challenges highlight the complexities and ambiguities in regulatory interpretations faced by merchant bankers and prompt us to reconsider whether ACL activity can be termed as a regulatory breach or merely a compliance oversight.
Regulatory Breach or Compliance Oversight?
Axis Bank, the parent company of ACL, contended that their actions complied with all the regulatory provisions and the guarantees provided were within the scope of permissibility as per the SEBI regulations. The interim order stated that “ACL activities were prima facie in violation of Regulation 13A of the SEBI (Merchant Banker) Regulations 1992”. Since the regulation does not expressly define the term “associated activities”, thus ACL activities may be classified under the ambit of associated activity in the security market as per Regulation 13A. SEBI in its consultation paper stated that there is a need to explicitly define the associated activities and incorporate such activities as a part of the regulation itself. Therefore, SEBI should consider amending the regulatory framework and, in the future, this type of activity should be categorized as a compliance oversight rather than a regulatory breach. SEBI’s action against ACL has substantial implications for future merchant bankers, signaling a critical juncture for the future of merchant banking in India.
Implications for Future Merchant Banking in India
SEBI's actions on ACL will have profound implications for future merchant banking. Firstly, the ambiguity around merchant banking-associated activities, especially those involving underwriting and guarantee. Underscore the need for SEBI to clearly define the boundaries in the regulations to avoid compliance failures stemming from misunderstood roles and responsibilities. This could result in an amendment to the regulation, to bring more clarity and reduce ambiguity. Second, in the future, merchant bankers will have to draw a fine line between acceptable market risk and prohibited repayment guarantees more precisely. Failure to misinterpret this line would lead to compliance failure, as seen in the ACL case. Drawing this line accurately will be critical to avoid regulatory breaches. Third, in the consultation paper, SEBI proposed stringent measures to curb the market activities of merchant bankers. It will likely increase the compliance cost of the merchant banker due to the need to align with the more stringent regulatory framework. It could involve thorough due diligence, developing more detailed operational manuals, and investing in regulatory technology to ensure adherence to SEBI's evolving regulatory framework.
Lastly, in the long run, SEBI's intervention may push forward for more market integrity. Precisely defining the role of merchant bankers ensures that their activities do not pose systematic risks to the financial market. By imposing restrictions on the activities that blur the line between underwriter and repayment guarantee, SEBI reinforces that merchant bankers must strictly adhere to the scope of issue management.
Closing Thoughts
SEBI’s action against ACL, barring it from participating in merchant banking activity basis the alleged compliance failure with Regulation 13A of the regulations, signifies the critical need to clarify and define the MB's role. Also, it illustrates the broader challenges encountered by merchant bankers in navigating complex regulations, specifically the blurred lines between underwriting and prohibited guarantees. This highlights a gap in the regulatory framework, where the activities are not explicitly defined leading to compliance failure.
This case underscores the need for SEBI to amend the regulations to prevent similar compliance failures. it will eliminate ambiguity and enforce stricter compliance. For merchant bankers, increased scrutiny means higher operational costs, strict adherence to issue management, and thorough due diligence. Ultimately, SEBI’s intervention is toward safeguarding market integrity by enforcing clear boundaries and preventing merchant bankers from taking undue risks disguised as market activity.
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